Question

A company presents its accounts for inventory on the LIFO basis. In the questions below, you need to perform the necessary conversions to FIFO to obtain a just comparison with peer companies.
The necessary financial information for the company for the year ended 31.December 2019 is presented below:

Statement of Financial Position as at 31 December 2019
US $million	2019	2018
Inventories	950	905

Statement of Profit or Loss and Other Comprehensive Income for the year ending 31 December 2019

Sales	8 100	7 400
Cost of sales	5 200	4 050
Depreciation and amortisation expense	605	720
Selling, general and administrative expense	900	750
Interest expense	92	65
Profit before tax	1 303	1 815
Income tax expense	378	526
Net income	925	1289
The LIFO reserve for each year	255	135
The effective tax rate	29%	29%

7.1 Explain each of the LIFO and FIFO methods of inventory valuation. Discuss when a company may choose to use LIFO rather than FIFO. Include in your response an explanation of the LIFO Reserve. (4)
7.2 Calculate the following using the FIFO method for the company for the year ended 31 December 2019:
7.2.1 Inventory value (2)
7.2.2 Cost of sales (2)
7.2.3 Net profit after tax. (2)

Answer 1

LIFO

LIFO stands for last-in-first-out. It is an inventory valuation method which assumes that the last items placed in inventory are the first sold during an accounting year. While the default inventory cost method FIFO (First In, First Out), business have an option to elect either of the two.

Please note that once the company has opted for LIFO method, they can’t switch back to FIFO unless they get an approval to change from the IRS. The IRS does allow businesses to change from FIFO to LIFO inventory accounting, but it requires an application Form 970 in order to do this. The company must file the form with tax return for the year in which they first used LIFO.

The LIFO method is used in the COGS (Cost of Goods Sold) calculation when the production cost or cost of acquiring inventory is increasing due to certain reasons, for example inflation

While the LIFO accounting method may result in a decrease in profits for the company, it can also mean less corporate tax. Should the cost increases last for some time, then these savings could be significant for a business.

Currently LIFO is permitted to be used only in the United States, under rules set out by GAAP

FIFO

The more commonly used accounting method FIFO or First In First Out method, is used to estimate the value of inventory on hand at the end of an accounting period and its cost of goods sold during the period.

This method assumes that inventory purchased first is sold first and newer inventory remains unsold. Thus cost of older inventory is assigned to COGS and that of newer inventory is assigned to ending inventory.

FIFO is a more easier way of valuing inventory and more widely used as well.

Under the below mentioned conditions the company uses either of the valuation method

Reason for Using FIFO Instead of LIFO

If a company’s cost of inventory items are continuously increasing and the company has been experiencing operating losses and negative taxable income, the use of FIFO means matching its oldest/lower costs with its current sales. The result is a larger gross profit and a positive operating income.

Reason for Using LIFO

If a company’s costs of inventory items are continuously increasing, a profitable company will have lower income tax payments with LIFO. This results from matching the most recent higher costs of its items to the most recent sales. (The higher cost of goods sold means lower net income and lower taxable income than FIFO.)

LIFO reserve

LIFO Reserve = FIFO Valuation - LIFO Valuation

The LIFO reserve is the difference between the cost of inventory calculated using the FIFO method and using the LIFO method. The ideal reason for valuing an inventory using LIFO is usually defer the payment of income taxes by increasing the cost of goods sold, the LIFO reserve essentially represents the amount by which an entity's taxable income has been deferred by using the LIFO method.

The entire LIFO reserve concept disappears if a business uses a weighted-average method to recognize the cost of its inventory, since that approach uses cost averaging, rather than cost layering, to determine the cost of an inventory.

Calculation

FIFO Inventory value = LIFO inventory + LIFO reservue - LIFO cash

Particulars	2018	2019
Inventory	905	950
LIFO Reserve	135	255
(-) Cash (LIFO reserve * Tax Rate)	-39.15	-73.95
Inventory Value	1000.85	1131.05

FIFO COGS

FIFO COGS = LIFO GOGS - Change in LIFO Reserve

Particulars	2019
COGS	5,200
Changes in COGS (5,200 - 4,050)	1,150
COGS	4,050

Profit After Tax

Particulars	2018	2019
Sales	7,400	8,100
Cost of sales	4,050	4,050
Selling, general and administrative expense	750	900
EBITDA	2,600	3,150
Depreciation and amortisation expense	720	605
EBIT	1,880	2,545
Interest expense	65	92
PBT	1,815	2,453
Tax (PBT *29%)	526	711
Profit After Tax	1,289	1,742